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Do Gold and Silver ETFs Make Good Investments? – TheStreet

By Alix Steel October 5, 2010

Editor’s note: As part of our partnership with PBS’s Nightly Business Report, TheStreet’s Alix Steel will appear on NBR Tuesday (check local listings) to discuss what you should know before investing in gold or silver ETFs.

NEW YORK (TheStreet) — Silver and gold prices are hitting record highs, making physically backed exchange-traded funds very tempting investments. Before you buy, here’s what you need to know.

There are five physically backed ETFs traded in the U.S.: The biggest, SPDR Gold Shares(GLD); the cheapest, iShares Comex Gold Trust(IAU); the newest ETFS Physical Gold Shares(SGOL) and the two silvers, iShares Silver Trust(SLV) and ETFS Physical Silver Shares(SIVR).

When you buy gold and silver physically backed ETFs, you do not own the physical metal, you own a paper representation. With respect to the gold ETFs, for every share you buy, you “own” one tenth of an ounce of gold; for silver, it’s one ounce.

The actual metal is stored by a custodian, usually one of the large banks like JPMorgan(JPM) or HSBC. The share-to-metal correlation erodes the longer you hold the shares. The fund must sell gold, for example, periodically to pay for expenses which decreases the amount of gold allocated to each share.

If investor demand outpaces available shares then the issuer/trustee must buy more physical metal to convert it into stock. Conversely, when investors sell, if there are no buyers, then the metal is redeemed, the trustee must then sell the metal equivalent. Precious metal ETFs are not owned for leverage, but simply as a vehicle to track the spot price.

Investors are not typically encouraged to redeem their shares for the metal although it is possible. With respect to the SGOL, for example, an investor would have to redeem in whole lots of 50,000 shares (5,000 ounces, or $6.65 million) but only through an authorized participant. This is more feasible for high net worth individuals and funds but not really for retail investors.

Because you own shares and not the physical metal, precious metal ETFs may be sold short, so two people can own the same “gold” — the original owner and the investor who is borrowing the shares. Although baskets of shares are allocated to specific gold bars, which can be found in the ETF’s prospectus, an investor must share ownership.

Owning a precious metal ETF can also be more expensive than owning and storing the physical metal. Expense ratios can range from 0.25% to 0.50%, while storage fees at GoldMoney.com, according to founder James Turk, for example, cost 0.15% to 0.18%.

Profits made on investments in physically backed ETFs are taxed like collectables, at a maximum of 28%, if the investment is held for more than a year. If an investor sells before the year is up, he is taxed at his regular income rate. Basically an investor gets taxed as if he owned bullion, when in reality he just owns paper.

There are also two types of gold stored in the ETFs, allocated and unallocated. Allocated gold is the bullion held by the custodian. Custodians provide a bar list of all the individual allocated bars daily and are typically audited twice a year, paid for by the sponsor, by an independent party like Inspector International.

Unallocated gold relates to authorized participants like JPMorgan or Goldman Sachs who trade gold futures. Futures contracts are often bought if the trustee needs to create new shares fast and doesn’t have the time to buy and deliver the bullion. Typically allocated gold far outweighs the unallocated gold and the amounts are tallied each day by the custodian.

Those are the facts around silver and gold ETFs, now for the controversy.. For examples, I will use the GLD’s prospectus as a proxy as it is the second largest ETF in the world.

First off, there are questions as to the quality of the gold and silver in ETFs. Page 11 of the GLD’s prospectus reads, “neither the Trustee nor the Custodian independently confirms the fineness of the gold bars allocated to the Trust in connection with the creation of a Basket.” Basically you don’t know the grade of the gold you “own.”

Secondly, the trustee does not insure the gold, the custodian does and their liability is very limited. The custodian is only made responsible for damages to the gold they directly inflict, but if the gold isn’t good or is in fact wooden bars painted gold (but they didn’t do it), then most likely the custodian would be protected and the trustee wouldn’t be liable.

Also hidden in the prospectus is the fact that a custodian is free to store the gold with sub-custodians until the gold is delivered to the custodian’s main vault. In other words, the gold can be in various places at once. When the gold is with the sub-custodians, it’s on its own. The prospectus says “failure by the sub-custodians to exercise due care in the safekeeping of the Trust’s gold bars could result in a loss to the Trust.”

The sub-custodians are not accountable for the gold they store and are also free to appoint other sub-custodians to hold the gold. The trustee also has no right to visit the sub-custodians to examine the gold or check out its records. The trustee may visit the gold in the custodian’s vault but only on a limited basis. There is usually one independent audit at the end of the year and one surprise audit.

Also, since most custodians are banks, if they fail, the trust becomes an unsecured creditor. There might be a substantial delay or fees associated with obtaining the allocated gold. Granted the custodians are reputable large investment banks, but as we saw in 2008, any of them can become insolvent.

Another big issue some analysts have with the ETFs is the fact that JPMorgan and HSBC, both custodians, have short positions in the gold market. Chris Powell, secretary and treasurer of the Gold Anti-Trust Action Committee, which argues that governments manipulate the gold price, says “[We] doubt the reliability of the major gold and silver ETFs … [because] their metal can be borrowed by parties seeking to drive previous metal prices down, against the interest of ETF investors … [these short] positions are not disclosed in the ETF prospectuses.”

Nevertheless, the GLD has rallied 17% this year in tandem with the gold price.

Another worry is that because the ETFs can have unallocated futures contracts, they might have to roll over their futures positions and get caught out of the money, namely that the contract they hold would become worthless.. In that scenario, the ETFs would not be as closely correlated to the spot price of their underlying metal but to options expirations instead.

Don Dion, portfolio manager of ETF Action, argues that the rollover issue is more of a problem with gold exchange-traded-notes that are entirely based on futures contracts. “Since physically backed ETFs don’t rely on futures contracts for their strategy, price dislocation is not an issue … [Investors] don’t have to worry about the rolling of futures impacting the price of their fund.”

These issues have led many gold bugs and conspiracy theorists to shout warnings about the safety of precious metal ETFs: Does the gold you think you own really exist and in what form?

However, despite these risks, for an investor looking for pure exposure to the gold price, ETFs are an attractive option to trade, speculate and hedge.. Here are the facts you need to know about the five physically backed silver and gold ETFs available in the U.S.

GLD, SPDR Gold Shares

The GLD is almost 6 years old, born Nov. 18, 2004, and is now the second biggest ETF in existence. The GLD is worth $55 billion and holds 41.8 million ounces or 1,301.91 tons. Currently its fee is 0.40% but that might rise in 2011.

The trustee for the GLD is Bank of New York Mellon(BK) and the custodian is HSBC. According to the Web site, all the gold is held at HSBC’s London vault. HSBC’s sub-custodians are Bank of England and London Bullion Market Association.

The GLD is by far the most popular gold ETF in existence. It attracted strong investment demand over the last few years by enticing some big named investors. Paulson & Co. is the largest shareholder with 31.5 million shares. Northern Trust(NTRS) and Bank of America(BAC) own 11.6 and 8.9 million shares respectively. Soros Fund Management, founded by George Soros, is the seventh largest holder with 5.2 million shares.

The GLD’s sponsor is the World Gold Trust Services, a subsidiary of the World Gold Council whose sole purpose is to “stimulate and sustain the demand for gold” and whose members are the largest gold producers in the world including Barrick Gold(ABX), Goldcorp(GG) and Newmont Mining(NEM).

IAU, iShares Comex Gold Trust

IAU has been around since January 2005 and its claim to fame is that it’s the cheapest gold ETF. The fund has $4.2 billion in assets and holds 3.2 million ounces, or 99.70 tons of gold. The trustee recently lowered the expense ratio from 0.40% to 0.25%. According to the prospectus, there can be no unallocated gold held at the end of each business day. The trustee is allowed to request up to 430 ounces of unallocated gold for delivery from the custodian.

The trustee is Bank of New York Mellon and the custodian is JPMorgan. The gold is held in New York City, London and Toronto by the Bank of Nova Scotia(BNS). According to the Web site, the vault was last inspected in December 2009 by Inspectorate American Corporation. At that time the 8,553 gold bars in both Toronto and NYC all had purity of 99.50% to 99.99%. There has not been an audit since that date.

According to its most recent 13-F filing, Schroder Investments initiated a position in IAU with 1.74 million shares. Blackrock Institute holds the most shares at 12.2 million followed by Wells Fargo(WFC) and Bank of America with 8.6 million and 7.4 million shares respectively.

SGOL, ETFS Physical Gold Shares

SGOL is the newest gold ETF and was launched in September 2009. The fund has $955 million in assets and 752,017 ounces with an expense ratio of 0.39%. Although the ETF is small, year-to-date it has grown 146% in terms of ounces. There is unallocated gold but according to the prospectus not enough to make up a whole bar of gold.

The trustee is Bank of New York Mellon, the custodian is JPMorgan and the gold is held in Zurich, Switzerland. The Zurich sub-custodian is UBS.. The last audit was by Inspectorate International in December 2009 . The 757 gold bars examined, at that point, were of 99.50% to 99.99% purity. The inspection was at the sub-custodian’s vault and there were no anomalies found.

In the second quarter, Goldman Sachs(GS) bought 102,195 shares of the SGOL, making it the second largest investor behind JPMorgan, which holds 398,153 shares. Morgan Stanley(MS) comes in third with 85,093 shares.

SLV, iShares Comex Silver Trust

The SLV was launched in April 2006 and currently has $6.9 billion in assets with 314 million ounces or 9,782.88 tons. Its expense ratio is 0.50%. Reportedly no more than 1,100 ounces can be unallocated at the end of each business day.

Bank of New York Mellon is the trustee and JPMorgan is the custodian, no sub-custodians were listed. The silver is located in 5 vaults around London.. The last inspection by Inspectorate International reported was in February 2010. The existing 308, 542 silver bars were of 99.90% to 99.99% purity. About 1% of the bars checked had a few branding and serial number issues but reportedly those have been rectified.

Bank of America is the largest holder with 7.7 million shares followed by Aletheia Research and Morgan Stanley with 6 and 5.7 million, respectively.

SIVR, ETFS Physical Silver Shares

SIVR was born July 2009. The ETF has about $229 million and 10.7 million ounces of silver, which is up 17% this year. Its expense ratio it 0.30% but will rise to 0.45% in 2011. There is unallocated silver but according to the prospectus not enough to make up a whole bar of gold.

The trustee is Bank of New York Mellon, the custodian is HSBC and the silver is stored at HSBC’s vaults in London. The last inspection by Inspectorate International was in December 2009 and at that time there were 9,583 silver bars of high purity, 99.90% to 99.99% and there were no problems found.

Portola Group owns 413,300 shares and is the largest holder followed by Goldman Sachs and Pekin Singer Strauss Asset Management with 243,347 and 173,725 shares, respectively.

Silver and gold ETFs can be a smart way to diversify your portfolio including giving you an easy way to hedge risk or short the precious metal. They also allow you to track the spot price with limited hassle, but before you invest know the risks. If you want the physical metal, go buy it and store it yourself for limited downside.